Bank Stress Tests and Other Acts of Faith

rcwhalen's picture

First it needs to be said that the Fed deserves credit for conducting these stress tests, flawed as they may be.  Would that the Fed had followed policies over the past 30 years that made this exercise unnecessary.  But the fact of a standardized annual stress regime is not a bad thing.  The difficulty comes because economists are involved.

The first rule of financial analysis is that you never mix apples and organges, namely financial analysis and economic guesswork.  The task of analytics is to stress the enterprise in an operational sense, then comes the job of trying to relate these observed limits with the outside world.  Attempts to plumb econometric analysis into financial models are alway bound to create more noise than anything else.  But of course the Fed is run by economists and they cannot help themselves when it comes to building models.

With that caveat, let's compare the Fed stress test results with the Economic Capital ratings produced by my partner Dennis Santiago at our ratings firm IRA.  Unlike the econometric mumbo jumbo produced by the Fed as the framework of assumptions for the stress tests, at IRA we use the balance sheet alone to generate a maximum probable loss for three buckets: trading, lending and investing.

The sum of these three stressed MPL estimates is designated Economic Capital or "EC."  Divide income by EC and you have Risk Adjusted Return on Capital or "RAROC."  We then compare EC with Tier 1 Risk Based Capital ("RBC") and produce a ratio between how much capital the bank has vs. the risk-based world of EC.

Then we compare this risk-based output with the public data Bank Stress Index ("BSI") and CAMELS ratings published each quarter by IRA.  The table below show the BSI letter ratings from The IRA Bank Monitor for many of the stress test group banks as of December 31, 2011 and the ratio of EC to T1RBC.  Foreign BHC ratings are for the US units only. 
IRA Bank Monitor -- Q4 2011

Name Rating BSI Score EC:T1RBC
JPMORGAN CHASE & CO. A 1.38 5.845
CITIGROUP INC. B 1.96 2.709
U.S. BANCORP A 1.21 1.17
A 1.2 1.343
A+ 0.88 2.99
C 2.12 1.635
C 2.09 0.614
A+ 0.82 0.113
Industry Benchmark Year (1995) A 1 NM

Source: FDIC (RIS)/The IRA Bank Monitor        

If the bank has an EC to T1RBC ratio much greater than 1, the model is telling you that the risk taken by the enterprise exceeds the ability of the nominal regulatory capital to support it.  Notice that JPMorgan and not Citigroup ("C") is the outlier when you look at the group based upon EC, followed by State Street ("STT"), Toronto Dominion's US units and Goldman Sachs ("GS").   Note that the IRA ratings are a mechanical survey with all the participants treated the same.

So when I look at the Fed stress tests, which seem to be the result of a mountain of subjective inputs and assumptions, the overwhelming conclusion is that these tests are meant to justify past Fed policy.  Policy like alowing large banks to pay dividends and, especially, move loan loss reserves back into income by most of the TBTF banks.  Significantly, US Bancorp and smaller institutions have generally not played this dangerous game with loan loss reserve releases back into income because they could easily cover the dividend.

One of the first things to notice about the conflict between economic and analytics is the mismatch between the HPI series in the Fed stress assumptions and the losses allocated to second lien loans.  The $56 billion in total losses for all participating banks (Figure 9) is way, way too small if HPI is going to fall another 20%.  Try more like $200 billion.  In fact, you could haircut Wells Fargo and C second lien portfolios by $50 billion each today given where the HPI stands.

But as we have written over the past several weeks in The Institutional Risk Analyst, the Fed does not want to believe that there is a problem with real estate.  As my friend Tom Day wrote for PRMIA's DC chapter yesterday: "It remains hard to believe, on the face of it, that many of the more damaged balance sheets could, in fact, withstand another financial tsunami of the magnitude we have recenlty experienced and, to a large extent, continue to grapple with. "

Then again, look at the mere $62 billion loss on first lien mortgages in the supervisory stress scenario.  Since real estate is half the total $13 trillion balance sheet of the US banking system and more like 3/4 of total exposure if you include RMBS, how does the Fed manage to keep total real estate losses below $150 billion in the stressed scenario?   Again, the Fed party line is that there is no problem with real estate.  But to be fair to the Fed, they are looking at the same baked and spun disclosure from the TBTF banks as we all.  There were reports that the Fed initially wanted to ignore the 2009 FASB rule changes in fair value of illiquid assets, but banks pushed back and insisted on "new GAAP" as the rule.

The big eye opener which is NOT a surprise in the stress scenario, at least if you've been paying attention, is watching C catching up with Capital One Financial ("COF") in terms of total loan loss rates (Figure 10).  C is clearly the outlier among the top four zombie banks, but to see the loss rate for C catch COF in the stress simulation is really mind boggling.  First, it just confirms our view that the C business model remains decidely subprime.  But also suggest that in a stress scenario, such distinctions start to blur.

The median loss rate for the whole group of 7%.1 percent is bad enough and well above losses reached during the recent crisis, but look at Amex, Bank America ("BAC"), Regions "RF") and Wells Fargo ("WFC") all well above the line.   And then look at WFC as the second leading loss rate institution behind C in first liens.  This confirms my long held view that the aggressive accounting and lending practices at WFC are masking a far more risky franchise than Warren Buffet and others like to believe.  Or as I said on "Fast Money" this week, the REO hidden inside banks like BAC and WFC is probably equal to what they show us on the books today. 

When you get to junior liens and HELOCs (Figure 13) you will understand why I have been saying that Ally Financial and BAC need to be restructured.  With a plus 20% loss rate on second liens, Ally has substantial capital issues to put it mildly.  But look at C right behind them with a loss rate in the mid-teens followed  by BAC.  Yikes.  This type of loss rate is typical for credit cards and both of these second lien portfolios are > $100 billion. 

And the real lesson, dead friends, is that the good old USA is a subprime nation, a society of individuals whose aggregate propability of default is probably around a "B" to "CCC."  Covert the loss rates in the stress tests to bond ratings using the break points from Moody's or S&P and tell me what you see.

Last point on Ally Financial:  Yikes.  Probably weaknes results of whole group.  Memo to POTUS: File Ch 11, sell auto biz, bank to GM in 365 sale.  Liquidate ResCap.  Declare success.  But do not be surprise if BAC follows if Ally goes into bankruptcy.  The one thing that the Fed almost completely ignores is the vast financial risk facing BAC and Ally, and to a lesser degree, WFC, JPM and C.

While on Page 37 the Fed states that "PPNR projections also incorporate the incremental impact of the recent mortgage related settlement between several of the CCAR BHCs and state and federal authorities," but this does not include estimates for put-back and fraud claims that are orders of magnitude larger than the foreclosure settlement.  If there is one key area where the Fed analysis reveals some fundamental weakness is an appreciation for the size and proximyty of some substantial financial and reputational risks to many banks in RMBS litigation.

See you on CNBC "Squawk Box"  ~ 8:30 tomorrow.

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ABELIA's picture

Attempts to plumb econometric analysis into financial models are alway wired to create more trouble than anything added.  But of way the Fed is run by economists and they cannot aid themselves when it comes to structure models

michael1234's picture

when I seeming at the Fed jumps tests, which seem to be the aftereffect of a hindrance of subjective bravery and mississauga condos for sale assumptions, the overwhelming finish is that these experiment are meant to justify past Fed policy.

winslet231's picture

Great post. And you hit the nail on the head. The Fed tells the public they have a severe anxiety test that assumes we have a ebb or residence prices go down, etc, which get highly publicized of course, because as web hosting company Larry Summers points out, "We rank certainty in our banking system".

chilaster's picture

stipulation you chuck them the category mothers day greetings, and on one occasion in a while a non-judgmental chuckle.

jaanp444's picture

The strain of analytics is to evince the drive in an active sense, then comes the job of disagreeable to think mothers day greetings these observed limits with the outside experience romantic status.

Sechel's picture

Great post. And you hit the nail on the head. The Fed tells the public they have a severe stress test that assumes we have a recession or home prices go down, etc, which get highly publicized of course, because as Larry Summers points out, "We need confidence in our banking system".

But the media gets a fail here. Nobody is vetting the reasonableness of the implied default rates and severities or even comparing the "fair value" price to the market price for the assets(to stick with mortgages).

The result of all this, for the intelligent investor is to not trust or invest in the banks as the accounting is one big sham.  And if you do make the mistake of trusting your assets to a bank you'll learn that the laws protect the banks and not your assets as you pointed out in your post on MF Global and how the Bankruptcy laws in 2005 subverted what should be customer first lien status into unsecured creditor(great Bill Rochelle video). or that investing in first lien mortgages makes you junior to banks who hold 2nd lien mortgages.

Piranhanoia's picture

Can anyone be so deeply confused as the author.  No.  They would have to be a friend of the fed to or delusional.  The first sentence of liquified bullshit soup is enough to realize the rest is part of a 7 course roadkill supper.   

Hickory's picture



Whelan seems unsure as to whether the stress tests amount to a conscious exercise in sentiment management by the Fed, or an unrealistically optimistic view arising partly from regulatory capture and partly from the self-defeating tendencies of economists confronted with a problem in financial analysis.  These would include a proclivity for introducing economic assumptions too early in the analysis, and a desire to believe that their past policies – particularly as they relate to residential real estate – have worked.  If asked, Whelan would probably reply that it’s all of the above.  


But he ignores a third possibility:  That the Fed’s economists are confident that real estate losses won’t be too big an issue because it is within their power to make real the assumptions in the stress test  concerning RE losses by bringing about an inflation in asset values.

That has to be a large part of the explanation.  The points that Whelan makes concerning the current financial condition of the zombies may be perfectly valid,  but it’s quite a stretch to believe that the Fed staff has not been able to comprehend and fully take them on board.  (Chris and others have been making this case in public and private for quite a while, and he’s too respected a figure to ignore.)


stickyfingers's picture

The question shouldn't be if they can survive another recession, but rather when will they cause the next one.

sasebo's picture

And so the question remains --- Who needs these useless asshole, fat cat, greedy fraudulent bankers? Not me.

FreeNewEnergy's picture

Whalen is my banking hero. Caught him this AM on Squawk and have to admit that while he makes plenty of sense - and did a gentlemanly smack-down on Liesman, plus mentioned ZH on air - about 2% of the viewership probably understood roughly 1/2 of what he said.

Throughout the crisis and even before it, Mr. Whalen has been the one voice of truth. Too bad there's nobody listening and even the dearth of comments here show just how little anybody understands the banking system in the US, which is at the core of all of our problems.

Whalen and Jim Willie have been spot on all along and I am very appreciative of their efforts.

G_T_A_44's picture

One must ponder the following: Do the 'so-called' Stress Tests include the multiple balance sheets/books residing in hundreds of 'Off-Shore' Shells... a la Enron?

The 'PlayBook' of yesteryear remains 'In Play' with constant enhancements.

Corrupt F ups's picture

How about an annual global gold audit?  No need for any other stress tests.  Then we limit total contracts available to what actually exists.  If you want to create more contracts, produce more gold.  Probably too complicated.

Waterfallsparkles's picture

The Elephant in the room is the Put Back Mortgages.  There are so many Law Suits out there looking for forced Buy Backs on bad Mortgages.  So, many of the Banks have refused to Buy Back bad Mortgages and have been fighting to the Death Buying them Back.  This includes JPM with the Law Suits from Ambac, Mbia etc.

SwingForce's picture

I think he meant "dear friends".

PulledPorkBBQ's picture

Chris - does any of this include all the off-balance-sheet SIVs, etc?  If not, who cares?

Nacho Libre III's picture

Subprime is great. Once we finish destroying the dollar, we can bring all our manufacturing sector back home from Asia. It'll be wonderful, except the gas at $10/gallon part. By the way, most of the politically convenient grandchildren and children constantly invoked in quotes like " weve got to stop borrowing from china and saddling our children and grandchildren with debt" have zero intention of paying the first nickel anyway. So we should just keep borrowing for at least another decade or three. Our kids don't care about pricey gas, they only know how to ride bikes.

non_anon's picture

who believes this crap about stress tests? not i

kraschenbern's picture

This analysis, while interesting, obfuscates the issue of credit worthiness of our financial institutions.  But then, what else can one expect when "Too Big To Fail" is the rationale for backstopping the big boys via the taxpayer.  I say let the system crash; start over with strictly imposed bankruptcy laws and debtor prisons.  Then finance gets really easy to understand.

AnAnonymous's picture

So you buy much stuff through debt, let the system crash and enforce prison on the people who are going to go into debt to rebuy from you what you bought through debt?

US citizenism anyone?

LFMayor's picture

Remember, we have that all that opium from the 'stans now.  I bet if we light a ball and wave it under your nose, you'll start salivating and rubbing you lips.

You chinamen Want the happy smoke, don't you?  Again.

riphowardkatz's picture

That isn't what he said.

While I dont agree with debtor prison when people go bankrupt in the US they should be forced to liquidate the stuff they bought with debt. We should not be like the fascist/communist China that gives favors to party friends while 1 in 3 of its citizens are rice farmers who never can save enough to keep up with the ever growaing supply of yuan and are forced into indentured servitude from a wealth guzzling/redistributing government. 

Everybodys All American's picture

what's the point af a stress test when nobody uses mark to market accounting principals? Sarbox is a joke and so is this test.

MachoMan's picture

I'll add, what is the point of attempting to manipulate public perception of the health condition of the banks when the very act of a government arm performing a stress test necessarily reveals that there is a substantial likelihood of capital inadequacy in the subject banks?


Boilermaker's picture

..."See on CNBC Squawk Box tomorrow"

No, you won't.

LowProfile's picture

Survey says...

You're an idiot!  Unless of course, you meant YOU won't be watching Squawk Box, in which case, me neither.

ZH love three minutes in:

Nage42's picture


Watched the interview... impressive.  Presence, tonality, poise, pacing, just the right amount of "knee-kicks with a smile" to the other talking heads, comes off very charismatic.  Only suggestion I have is to adopt a slight change in eyes, that being:  rather than wide-open deer-in-headlights, aim for slightly lidded but eyebrows raised, with slight head tilt (in the same direction as speaker) and you will have that kind-benevolence with body mimic for immediate positive imprinting.  It goes without saying that the content was rock-solid, but your counterparties arn't there for their fundamentals understanding, their only tools are charisma, and you could toe-to-toe with them if you throw them the kind-eyes, and once in a while a magnaomous/indulgent chortle.

So sad that people like Ron Paul that have good morals/intelect just can't seem to be arsed to put some effort into public speaking and idea-delivery... it's like their ideal-ocrats, that the ideaoligy will float on it's merits... hahahahah, wake up and smell the plebs... *sigh*